A New Reason to Use the Mega Backdoor Roth IRA

Warning: We’re getting into the weeds today. This is definitely NOT a back to basics post.

As discussed in a previous post, the Section 199A pass-thru business tax deduction has forced us to revamp a large part of our financial lives. This deduction, designed to keep pass-thru business owners (sole proprietorships, partnerships, and S Corps) competitive with C Corps after the Tax Cuts and Jobs Act of 2017, is our new largest deduction (it used to be retirement account contributions and charitable deductions). Rearranging our financial lives in order to maximize it is well worth our time and effort.

Now there is no dictionary definition of super-saver, but the idea behind it is if you are going to be well into the top tax bracket in retirement, you may want to rethink the traditional tax-deferred advice and instead make tax-free (Roth) contributions and maybe even do some Roth conversions, even at the top tax rate.

There are a number of advantages for the very wealthy to having a larger portion of their portfolio in Roth accounts:

Better asset protection since more of the portfolio is in a retirement account instead of a taxable account

Despite those advantages, it’s still the right move for most docs to do tax-deferred contributions because of that arbitrage between tax rates. However, over the last few years as The White Coat Investor has seen unexpected financial success, more and more I have found myself looking at our tax-deferred contributions and wondering if we were doing the right thing.

We are certainly super-savers. Despite the kitchen renovation that has exploded into tearing off multiple walls of our house this Fall (more on that in future posts), generally living on 5-10% of your gross income has an interesting side effect of causing your portfolio to grow very rapidly despite large charitable contributions.

It seems a virtual certainty at this point that our marginal tax rate in retirement will at least be the equivalent of the 32% tax bracket and quite possibly 37% if our success continues for just a few more years. (Ask me how this feels knowing there was no Roth TSP while I was in the military with a taxable income under $100K).

It is now quite possible that we will have an estate tax problem I never expected, especially if the estate tax exemption is lowered at some point in the future. While I fully expect to cure our estate tax problem by simply increasing gifting and charitable contributions, having more money in Roth accounts instead of tax-deferred + taxable accounts does reduce the size of our estate and provide more options.

All of that already had me thinking about changing over to Roth 401(k) contributions for the employee portion of our 401(k)s, but when the TCJA was passed, it was the final nail in the coffin. Not only was it quite likely that we were better off with Roth contributions, but now we weren’t even getting a 37% deduction on our solo 401(k) employer contributions since they are subtracted from the Ordinary Business Income on which the 199A deduction is calculated. We were only getting a 37% * 80% = 29.6% deduction. It seems really silly to take a 29.6% deduction now knowing we would be paying at least 32% at withdrawal on that money. So we have decided to stop making those contributions starting in 2019.

The Mega Backdoor Roth IRA

So are we just going to invest in taxable? No way. Tax-protected growth and asset protection is just too valuable. Instead of making “employer contributions” to our solo 401(k), we’re going to make employee after-tax contributions. We get no deduction for these contributions, and, if the 401(k) allows it, we can either do an instant Roth conversion of those funds inside the 401(k) or transfer the money to an outside Roth IRA, tax-free. This process (after-tax contributions + instant Roth conversion) is known as a Mega-Backdoor Roth IRA. If you thought a Backdoor Roth IRA was awesome, wait until you get a load of just how much money you contribute to a Roth IRA each year through a Mega Backdoor Roth IRA.

I’m ignoring the savings we do for our kids (Roth IRAs, UGMAs, 529s) and our taxable account contributions (actually the majority of our savings these days) here. But just looking at the tax-protected accounts, we’ve gone from sheltering $163K to sheltering $199.5K. If you actually adjust those tax-deferred amounts for our current marginal tax rate of 45.2%, we’ve gone from $98K to $160K, a 63% increase. But wait, there’s more.

Katie’s Pay Cut

By going to after-tax contributions for Katie, Katie no longer needs to make as much money as she used to in order to max out the 401(k). So I gave myself a raise and cut her pay dramatically. Yup, our family is voluntarily contributing to the gender pay disparity. But there is a method to our madness. Think about it. The White Coat Investor, LLC files taxes as an S Corp.

How much salary does she need to be paid in order to be able to contribute $56K to a 401(k) as employee tax-deferred and employee after-tax contributions? Well, $56K plus enough to cover her payroll taxes. How much did she need to be paid in order to contribute $56K to a 401(k) as employee tax-deferred and employer tax-deferred contributions? Well, $37K/20% = $185K + enough to cover her payroll taxes. So she can take a 75% pay cut and still max out that account.

“What? I still don’t get it? Why do you want to pay her less?”

Because, my young padawan, every dollar she gets paid as salary costs us 15.2% in payroll taxes. If we pay her $185K, we pay 12.4%*132,900 = $16,479.60 in Social Security taxes and 2.9%*185,000 = $5,365 in Medicare taxes. So we want to pay her as little as possible while still being able to max out that account and justify the salary to the IRS. (Since her job description is so flexible and those types of jobs typically don’t pay very much, that’s pretty easy to do. How many of you are paying full-time employees less than Katie is paid part-time?)

The issue, of course, is that the 199A deduction, at least at our income level, is partially based on the salaries our company pays. So if we pay her less money, our 199A deduction shrinks proportionally. That’s no good. So what’s the solution? We just pay me more. So she took a big pay cut and I got a big raise. Yay me! Overall, the total salary paid by the company will be similar so the 199A deduction will be similar.

So why did I get the raise instead of her? Are we sexist? Nope. Remember I have that other job down at the hospital. Even if I were only making $56K with WCI, I would still pay the maximum Social Security tax each year. That’s not the case for Katie whose only job is with WCI. The bottom line is that we’re saving Social Security taxes on the difference between the 2019 Social Security wage base ($132,900) and the salary we pay Katie (about $64,000). ($132,900-$64,00) * 12.4% = $8,544. There is no Medicare tax savings of course, since we’re getting the same total salary as a couple and it’s all subject to Medicare. And half of that SS tax we would have paid for Katie is deductible, so it’s really only $6,613 we’re saving but hey, $6,613 more than covers a luxurious six-day heli-skiing vacation. It’s real money.

Other Retirement Account Changes

#1 Cash Balance Plan Contributions

The careful reader will notice a few other changes in our retirement account line-up for 2019. My cash balance plan contribution went down. I’m pretty annoyed with it, but we changed plans this year. The new one admittedly has a better design, but its structure has a nasty side effect for young super-savers. Whereas the old plan let everyone contribute up to $30K, in the new plan the contribution limits are determined by age.

<35 $5K

36-40 $7.5K

41-45 $17.5K

46-50 $40K

51-55 $80K

56+ $120K

I turn 44 in 2019, so it’ll still be a couple of years before this change works out better for me.

#2 Partnership 401(k) over WCI 401(k)

You will notice I am now using my $19K employee contribution at the partnership 401(k) instead of the WCI 401(k). It made a lot of sense to use it in the WCI 401(k) when I was making more money practicing medicine than running WCI. Now the situation is reversed. I don’t actually make enough clinically to max out the partnership 401(k) even if I use the employee contribution there, but I can contribute more overall if I use the employee contribution there instead of our individual 401(k). Our partnership’s new 401(k)/PSP actually allows employee contributions now, so I will just do that.

#3 Tax-Deferred Partnership 401(k) Contributions

You will also notice that I am doing tax-deferred contributions to my partnership 401(k). Remember that income is not eligible for the 199A deduction because medicine is a specified service business and our taxable income is well over the $315-415K limit. So that deduction is still worth 37% (federal) to us rather than 29.6% like it would be in the WCI 401(k). Maybe we’ll be in the 37% bracket in retirement, maybe we won’t, but we’ll certainly be in a bracket higher than 29.6%. At least for 2019, we’ll continue to do tax-deferred contributions if they are available to us. We’re only talking about $19K here anyway, the rest (both the profit sharing portion and the cash balance contribution) have to be tax-deferred.

You will notice Katie’s employee contribution is also tax-deferred. That income is deferred from her salary, and so doesn’t count toward Ordinary Business Income for the 199A deduction, so it still provides us a 37% (federal) deduction. We’ll continue to use that for 2019 for the same reasoning outlined above.

Additional Complexity Using a Mega Backdoor Roth IRA

It’s pretty obvious to see the advantages of these changes for us. We’re able to protect a ton more money after-tax, really maximize the value of our retirement accounts, and even lower our payroll taxes (pretty much a free lunch in our case). The big downside, unfortunately, is additional complexity. As if our financial lives weren’t complex enough already.

For years we’ve had the WCI 401(k) at Vanguard. Vanguard’s individual 401(k) has its issues. The customer service isn’t awesome, they don’t allow IRA rollovers, and until recently, they didn’t let you buy the lower cost admiral shares funds. But it was good enough for our purposes for a long time. The big problem now, however, was that the Vanguard individual 401(k), at least the off-the-shelf version, doesn’t allow after-tax employee contributions or in-service conversions/rollovers, the two features necessary to do a Mega Backdoor Roth IRA. As I looked around at the other off-the-shelf individual 401(k)s, (Fidelity, Schwab, eTrade, TD Ameritrade) I found that none of them really allowed this. I would need to go to a customized plan and I was going to need professional help to do so. And professional help is rarely free and often quite expensive.

A Customized Mega Backdoor Roth IRA Plan With mysolo401k.net

After shopping around a bit, I settled on mysolo401k.net. The fees were low and their website actually discussed the Mega Backdoor Roth IRA in detail. I thought that was a good sign. Within minutes I had the head of the company, Mark Nolan JD, on the phone answering my questions. It was such a good experience I thought they would make a great new affiliate partner for The White Coat Investor. It’s always easier to plug companies that I actually use. At first, they agreed to not only pay me an affiliate fee for new business I brought them, but also discount their fees from $795 up-front plus $125/year to $700 up-front plus $125/year. Win-win-win. Shortly after I did a podcast mentioning them, they backed out of the agreement and decided to just lower their fees to $500 up-front and $125/year. Lame for me, but it’s still a win for you and for them. Maybe I can talk them into sponsoring a podcast or something down the road.

Choosing a Fund Custodian

There was an incredible amount of paperwork involved. Pages and pages and pages and pages and pages. You see, mysolo401k.net isn’t going to function as the custodian of the funds. They had to go to either Schwab or Fidelity. I already had accounts at both (partnership 401(k) at Schwab and HSA/Credit Cards at Fidelity), but decided to go Fidelity because I thought I might just use the 0% ER index funds there. Of course, when there are two companies involved and 4 new accounts (a tax-deferred and an after-tax for both of us and we didn’t bother with the Roth accounts since we figured we’d just do rollovers to our Vanguard Roth IRAs) a few minor things were screwed up and had to be redone. But I was impressed with how much better the service was from both companies than what I’ve come to expect from Vanguard.

Once I got our 401(k) money over to Fidelity, I was disappointed to discover that I couldn’t buy the 0% ER Index Funds after all. No biggie, I just paid a $4.95 commission and bought Vanguard ETFs. This isn’t my first rodeo, but I was surprised that Fidelity didn’t want my business in that respect.

“Checkbook” 401(k)

Another great feature of having a 401(k) plan actually designed by someone who knows what the heck they are doing is that this is a self-directed “checkbook” 401(k). That means I can invest it in anything I want (except Fidelity 0% ER index funds apparently.) I suspect I will eventually take advantage of this feature to move some of my very tax-inefficient debt real estate/hard money loan funds out of taxable and into tax-protected.

Take Home Points

This post is long enough, let’s wrap it up. Here are the take-home points:

If you qualify for the 199A deduction, you might want to consider Roth and Mega Backdoor Roth 401(k) contributions.

If you want to do a Mega Backdoor Roth IRA in your i401(k), you’re going to need a customized plan.

After-tax 401(k) contributions allow you to max out your 401(k) on much less income.

Maximizing your use of retirement accounts helps you reach your financial goals faster and protect assets from creditors, but often introduces a lot of complexity to your financial life.

What do you think? Have you done a Mega Backdoor Roth IRA before? Did you make any changes to your retirement plans in response to the new 199A deduction? Comment below!

If a person had dual w2 and 1099 income but only made $100K 1099 income, qualifying for only $25K for pre-tax employer contribution to solo401k (already used employee contribution on the w2 401k), is there a limit for the remainder $31K for doing the megabackdoor roth?

I believe so. But more importantly, consider doing it all ($56k) as after-tax for the mega-backdoor roth. This is because the employer contribution reduces your net business income, which in turn decreases your 199a (20% of profits) deduction.

So if you thought you were getting a 32% deduction on that $25k pre-tax employer contribution, you’re only getting a 25.6% deduction

For super saver W2 employees who can’t do the Mega BD rIRA – How exactly does it work if you switch from making tax deferred 401(k) contributions for many years to Roth 401(k) contributions? Will all brokerages track the dollars separately to ensure no double tax on your Roth contributions? Or should you first do a Roth conversion on your deferred 401(k) contributions?

Great post! My wife is a real estate professional and often carries passive loss to deduct against my ordinary income so I’ve often thought about the deferred savings of today vs. mega back door roth. One point I think might be good to clarify is that savings of every dollar in a tax deferred 401k is at the marginal rate, but withdrawals in retirement will fill the lower tax brackets first. Reason I point this out is when I was first doing the calculations on this I made the mistake of comparing the marginal savings rate on deferral to the marginal rate on withdrawal and assumed if I saved 37% going in and paid that marginal rate in retirement then I was net neutral, but in fact the effective tax rate on withdrawal is lower. Many may already figure that, but thought I’d share.

Definitely getting into the weeds for sure on this one but an excellent post when you take the time to go through it. Definitely applicable to me and something else to think about.
Although you don’t have all the specifics, how would you typically advise someone who likely falls into the “super saver” category but won’t get the 199a deduction due to income. I

This is where I fall. Roth is better than taxable. Not sure how much traditional vs Roth I should do… I am going to start doing this on my new side business instead of investing in my taxable brokerage account (which I do after maxing all traditional retirement space). May even bleed down my taxable account a bit if I make enough to max out a mega back door Roth but not enough to pay the taxes on it.

Definitely getting into the weeds for sure on this one but an excellent post when you take the time to go through it. Definitely applicable to me and something else to think about.
How would you typically advise someone who likely falls into the “super saver” category (~40% gross income saved) but won’t get the 199a deduction due to income. For example – early 30s and just starting life as an attending, positive net worth, ~550k annual 1099 money as IC (so no chance of getting a 199a deduction), and i401k currently with Vanguard. Without the 199a deduction, I’m taking advantage of the tax arbitrage being in the highest tax bracket investing in tax deferred i401k. But, the potential for super saver issues down the road lends itself to more Roth money. I’m curious what you’d advise in such a situation for people who clearly don’t fit into an “obvious” category.
The good news is I already have a decent amount of Roth money due to annual contributions during residency (+ spousal contributions) and rolled over 401k money to Roth in the half year after graduating residency.
Thanks.

You indicated that by reducing Katie’s salary, you correspondingly reduce her social security/medicare taxes. Left unsaid (unless I missed it) is the point that a reduction in social security taxes may result in a reduction in social security payouts. This reduction would occur if Katie’s social security payments are based on her earnings history and not your earnings history, through a spousal payout. I’m guessing it will be the latter, which is why you didn’t qualify your statement.

Even if she is claiming under herself (doubtful), it’s still probably not a good deal to voluntarily pay extra social security it you’re past the first inflection point, which she likely is (if I remember correctly she was a teacher for a number of years in addition to WCI income).

I considered social security pay-out when determining my wife’s salary in our small business with an individual 401K. My CPA told me the general rule of thumb is that anything over $18K annual salary has no significant benefit in retirement income. I verified that her SS retirement would go up negligibly if we paid her $37K (max over-50 401K contribution for her plus Roth IRA contributions for both of us in 2017). And that was paying in for 10 years. Social Security is geared for the low income, so there’s little benefit for the extra employment tax withdrawal from larger salaries. I think anything you can save on employment taxes is near 100% savings if your salary is above about $20K. Tools on the SS website help you verify this for your own situation. Our case was relatively simple since I have a govt pension and any SS I might qualify for is offset by my govt annuity payment, so it was just her situation to consider. In the end we did pay her the max 401K/Roth IRA contribution salary (now $39K), since we are super savers. And now its all Roth 401K contribution, the taxable RMDs become massive in our later years so it doesn’t make sense to do any more traditional contributions, in fact we are converting as much to Roth as we can afford.

Thanks, looking at the bendpoints was educational, I should qualify my comment that it applies to someone with (perhaps substantially) less than 35 years of earnings (my wife will have 20 at best). The fundamental average that benefits are calculated on requires 35 years of earnings for significant benefit, zeroes are added to the average calculation for years not worked (under 35), bringing it down significantly. The increased benefit over a low wage earner could be substantial for a long term high income professional since “best 35” years of income are taken for the calculation. Nevertheless adding years of service or additional employment tax pay-out (salary) has little additional benefit and you’re getting beyond the FIRE objective if you work that long, so I still say that any savings on employment tax by reducing salary is advantageous. Again, you need to run the numbers for your own situation, I just think it a rare case where you want to pay more employment tax to get increased down-the-road social security benefit.

Awesome post! I hadn’t thought about the relative loss of 199a deduction with employee solo401k contributions. In my case I have military W-2 in an income tax-free state with both W-2 and 1099 California earned income (urgent care as a GMO). My initial thoughts were to prioritize tax deferred on the 1099/solo401k (minus the 5% Roth TSP match for BRS) since the military income was state tax-free while the California W-2 wages had half of SE taxes subsidized by my employer. I’d have to do the math on the loss of 199a deduction (not near phaseout by any means) but would you think this is a reasonable approach or should priority be for tax deferred employee contributions to the California W-2’s 401k plan with setting up megabackdoor Roth for the 1099 (or just employer contributions to solo401k?).

Thanks for the post. I was looking to transfer my 401k somewhere else to do aftertax contributions. Luckily I have been a bit sow/lazy. Now I am glad I procrastinated. Thanks for securing us with a discount rate 🙂

I happen to be in a position to only utilize this option for 2 years. I wonder if it is worth the fee of setting aside about $65k in after tax savings 401k savings? Is $750 worth it? I think it is.

The whole Mysolo401k, Fidelity en Custodian combo sounds more cumbersome than the “not off-the-shelf’ Vanguard solution I have used for several years. Open a Pooled Account (your 401k) at Vanguard, link a separate Roth IRA, and use all the Vanguard funds you want. You do need an actuary to set it up, indeed, but that is no big deal. Only issue with Vanguard is that you have to fill out a paper form to do the mega backdoor and send it in (unlike the regular backdoor you can do online), but that takes 5 minutes and is done within a week.

WCI, I thought you have employees and WCI 401(k) plan. How are you able to do Mega Backdoor Roth? Do you not have any W2 employees other than your wife? I am interested in learning about Mega Backdoor Roth options for LLC S-Corp with W2 employees and a 401(k) plan. May be a blog post?

A 401(k) plan for a practice with employees that allows for Mega Backdoor Roth IRA contributions can be designed for you. Not sure what else a blog post would say other than give you a list of people you can call to help you with it.

WCI, I am interested in the list. We have one high comp doc and low comp non doc spouse and for some the reasons you laid out, so far we did not really max out PS contributions for the non doc. Mega backdoor Roth space usage while passing various testing is useful for many small business employers including me.

Awesome post! I hadn’t thought about the 199a deduction being effectively reduced by making employee contributions to solo401k. Wondering what you would advise in my situation. I have military state tax-free income (doing 5% Roth TSP for BRS match) as well as per diem California W-2 and 1099 income (with three 401k plans, only match in TSP). I had initially planned to contribute remaining employee contribution tax deferred into my solo401k, then remainder as employer contribution. My thinking was that I was already receiving subsidized SE tax in the W-2 and save on the California taxes. Would it make more sense to put remainder in Cali W-2 401k plan to maximize the 199a deduction and then employer contributions in solo401k? Does megabackdoor Roth add any additional benefit?

Not sure I have enough info. Does your business even qualify for the 199A deduction? If so, then you may wish to avoid employer tax-deferred contributions to your i401(k) as it would lower your 199A deduction.

To be clear. At my w2 job if my employee contributions are 19k and employers contributions are 11k… would I only be allowed to add 26k in my i401k? How much income would I need to make so I could put 26k into it? 130k? Thanks

No, you could put $56K into your i401(k) if you had enough income in the business t o justify it. If you’re wanting to put in $56K as a tax-deferred employer contribution, you’ll need $280K of net income to do so. If you want to do $56K as a non-deductible employee contribution (assuming you’re an employee of your S Corp like me) you could do it with just $56K of icnome.

A lot in this great post. Trying to figure out the numbers for when this makes a good $$$ decision and worth the hassle. You could only do a post tax contribution up to your amount of side hustle or 1099 income, correct?. Say someone had $25k/ yr vs the full 55k. Ignoring actual ER in the funds:
Yr 1: $500/$25k = 2%.
$500/$55k = 0.9%
Yr 3: $500+$125*2/$25k*3 = 1%.
$500+$125*2/$55k*3 = 0.45%
Yr 5: $500+$125*4/$25k*5 = 0.8%
$500+$125*4/$55k*5 = 0.36%

While I can see a good argument for those being able to max from day one, I’m a little torn on the half way option. It’d probably take 5 years or more to beat the benefits of a low tax drag approached taxable account? But the idea of more Roth money certainly is appealing, just hard to predict 5 years from now both good and bad.

Obviously the less you have in there, the bigger the fee drag and the less the tax benefit. We’re putting $112K a year in there and rolled over hundreds of thousands as well, so $125/year is basically a rounding error for us. But your math looks fine to me.

A Roth account should, at a minimum, provide a benefit of something between 0.3-0.47%/year over a very tax-efficient taxable portfolio, not including the capital gains at sale which would further increase that. So I think it’s probably worth it for you if you stay at least 5 years.

This article is way above my head since my wife and I are W2 employees. However, I am interested if this is a viable “work around”? I suspect it is not worth it, but I am curious nonetheless.

If/when my wife (hopefully soon 🙂 ) gets pregnant, would there be any financial logic in having her take off to enjoy being a new mother longer than the 6 weeks allowed by our employer? Instead, have her take as much time as she wants and then use the money in her 403b from her previous employer to make a rollover into the RothIRA account and fill taxes as “married filling separately” in order for that rollover to be at a lower tax bracket?

This obviously would not be a primary motivator, but I like considering the options in case she doesn’t want to go back to work for a bit.

I have read this post over 3 times. I’m a super saver, but haven’t found nearly as good a strategy as this!

This Mega Backdoor Roth is really a complete game changer! It seems complex but I’m so willing to do it.
Please clarify my situation:
Right now my husband and I have mostly all W-2 income.
I have 32k a year in schedule C 1099 income. I contribute to my W-2 work Roth 401k 19k, and my employer contribute about 10k.
So I think your saying I could open up a separate i401k through solo401k and contribute up to my 32k earnings in after tax contributions and then directly convert to my Roth IRA?
And if I increase my 1099 income more to 56k I can still do my w-2 work Roth 401k for 19k plus whatever my employer contributes, and still contribute max of 56k into after tax solo401k?

My husband has no 1099 income right now, but if this is possible I need to convince him to do more speaking conferences, etc to earn 1099 income just for this purpose, right?

Great article. My understanding is that after tax contributions in the solo 401k fall under the umbrella of employee contributions. My understanding is that we are limited to 19000 employee contributions across all the 401ks. How can you make employee contributions in your partnership 401k and after tax contributions in your WCI 401k above the limit of 19000? Please clarify, maybe I have something wrong here.

I have a partnership 401k and I make both employee contributions (19k) and profit sharing and maximize it to 56k. I am also payed via 1099 by the hospital for extra call and I assume I could open a solo 401k and make the maximum 37k contributions as after tax contributions. Is this viable/legal as long as I am not part of a controlled group? Thank you.

“How much salary does she need to be paid in order to be able to contribute $56K to a 401(k) as employee tax-deferred and employee after-tax contributions? Well, $56K plus enough to cover her payroll taxes.”

I am missing something….since this $56K is AFTER-tax money, doesn’t she need to be paid enough to cover the relevant income taxes for that $56K (so….$56K + enough to cover her payroll taxes + enough to cover her income taxes)?

Maybe I am overthinking it…..That $56K is taxable money, so eventually when you do your tax return, the $56K gets lumped in with the rest of your taxable income, from which you determine “taxes due.” So I guess it doesn’t matter whether the money to cover those taxes was included in her W-2 income or instead came from one of your other buckets of income……is that right?

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